Unlevering and Re-levering Beta in DCF ●​ Debt/Equity Ratio: The proportion of

Model Application debt to equity in the company’s capital

structure.
●​ Beta - measures a stock’s volatility to Steps:
the overall market. However, this 1.​ Identify the company’s levered beta.
market risk also included the effect of 2.​ Determine the company’s debt/equity
the company’s debt (leverage), which ratio and tax rate.
can increase or decrease depending on 3.​ Apply the formula to find the
the capital structure. A beta of 1 unlevered beta.
indicates that the stocks moves in line Re-levering Beta: Formula and Steps
with the market, while a beta higher
than 1 suggests greater volatility, and a Blevered = Bunlevered x (1 + ( 1- tax rate) x
beta less than 1 suggests lower (Debt/Equity))
volatility than the market. Steps:
●​ Levered Beta (Equity Beta) - observed 1.​ Use the unlevered beta as calculated in
beta of a company’s equity, reflecting the previous step.
both business risk and the impact of 2.​ Apply the company-specific
leverage, meaning it reflects both debt/equity ratio and tax rate.
business risk and financial risks. 3.​ This levered beta will reflect the risk
●​ Unlevered Beta (Asset Beta) - associated with the company’s specific
removes the effects of financial capital structure.
leverage, isolating the business risk Application in DCF Model
alone. It allows analysts to compare In the DCF Model, after determining the
companies as if they were 100% rel+-levered beta:
equity-financed, providing a clear ●​ Use it to calculate the cost of equity
view of operational risks. via the CAPM
Why Unlever and Re-lever Beta in the DCF
Model? Cost of Equity = Rf + Blevered x (Rm - RF)
●​ Unlever Beta if using comparable
companies to determine a company’s ●​ Calculate the WACC by combining
risk profile. the cost of equity (re-levered beta
●​ Re-lever Beta for the company’s adjusted) and cost of debt, adjusted for
specific debt structure when tax benefits.
calculating the required return on Key Takeaways
equity. ●​ Unlevering beta isolates business
This ensures that the WACC used in risk, making it easier to compare
discounting cash flows is accurate and specific companies with varying debt levels.
to the company’s capital structure. ●​ Re-levering beta customizes the
discount rate to reflect the company;s
Unlevering Beta: Formula and Steps own leverage, critifcal for an accurate
To Unlever Beta WACC.
Bunlevered = Blevered ●​ Accurate beta adjustments improve the
1 + (1 - Tax rate) x (Debt/Equity) reliability of the DCF valuation
●​ Levered Beta (Blevered): Observed especially when using comparable
beta of the company company analysis.
●​ Tax rate: Marginal Tax rate of the ●​ Comparability Across Firms: By
company, typically corporate tax rate. unlevering beta, analyst can compare
 companies regardless of their capital
structures, isolating pure business risk.
●​ Customized Discount Rate:
Re-levering beta for the company’s
actual capital structure tailors the
discount rate, ensuring the DCF model
captures specific financial risk.
●​ Reliability in Valuation: Adjusting
beta improves the precision of DCF
valuations by reflecting the unique
risk profile of the company.
Common Pitfalls and Considerations
●​ Tax rate variability: use the marginal
tax rate for accuracy, as effective tax
rates can distort beta adjustments.
●​ Dynamic Capital Structures: The
debt/equity ratio can change over time.
●​ Market Comparables: Ensure that
comparable companies are from the
same industry and face similar
business risks for relevant unlevered
beta.
The Fama-French Model HML = Rhigh - Rlow
-​ An extension of the traditional CAPM.
-​ While CAPM uses only market risk to Rationale: value stocks often represents
explain returns, FFM identified two companies with lower growth expectations or
additional factors - size and value - temporary financial distress, leading investors
that more accurately explain stock to demand a higher return for holding these
returns across different portfolios. potentially riskier stocks.
-​ Widely used in finance for assessing
risk and expected return, especially in Fama-French 3 factor Model Formula
portfolio management and corporate
finance. R = Rf +( Bmarket x RMRF) + (Bsize x
Motivation Behind the Fama- French Model SMB) + (B value x HML)
-​ Certain stocks characteristics,
particularly size and value, Where:
consistently influenced returns beyond ●​ R = expected return
what CAPM could explain. ●​ Bmarket = Sensitivity of the stock to
the overall market.
The Fama-French 3 Factors Explained ●​ Bsize = Sensitivity to the size
1.​ Market Risk (RMRF) premium
-​ Excess return of the market ●​ B value = Sensitivity to the value
over the risk-free rate. premium.
Formula: Practical Application of the Fama-French 3
Market Risk = Rm - Rf factor model
a.​ Portfolio Management
Where: -​ use the model to design and adjust
-​ Rm is the return of the market portfolios to achieve specific
portfolio. risk-return profiles. By focusing on
-​ Rf is the risk-free rate. smaller-cap and/or value stocks, they
2.​ Size (Small Minus Big) can potentially increase expected
-​ Size factors measure the return returns, though with additional risk.
difference between small-cap and b.​ Cost of Equity Calculation
large-cap stocks. -​ Used as an alternative to CAPM in
-​ The return of a portfolio of small cap estimating the cost of equity. This is
stocks minus the return of a portfolio especially useful for firms in sectors
of large cap stocks with substantial size or value effects,
Formula: like small-cap stocks or value oriented
SMB=Rsmall−Rbig industries.
c.​ Performance Attribution
Rationale: smaller companies often face higher -​ Allows analysts to decompose returns
operational risk, fewer resources and less into factors, which is helpful for
access to capital, which can lead to higher understanding which elements
expected returns as compensation for these contribute to portfolio returns, aiding
risks. performance evaluation and decision
3.​ Value (High Minus Low) making.
-​ Value factor captures the return d.​ Asset Pricing and Valuation
difference between high book t market -​ Provides a more nuanced view of asset
stocks and low book to market stocks. pricing, especially for stocks that do
Formula
 not align well with CAPM’s premiums to better explain stock
assumptions. returns.
Calculating and Interpreting Each Beta Factor 2.​ Risk and Return Precision: It allows
●​ Bmarket: reflects sensitivity to overall investors to estimate expected returns
market movements, similar to CAPM. more precisely, especially for
●​ Bsize: indicates the stock’s portfolios that tilt toward small-cap
responsiveness to the size factor. A and value stocks.
positive beta suggests alignment with 3.​ Broad Use in Finance: The model is
smaller-cap stocks, while a negative valuable in various applications, from
beta indicates large-cap portfolio construction to performance
characteristics. evaluation and cost of equity
●​ Bvalue : shows the stock’s response to calculations.
the value factors. A positive beta
aligns the stock with value
characteristics, while a negative beta
aligns it with growth characteristics.
Limitations of the Fama-French 3 Factor
Model
●​ Ignores Other Potential Factors:
Some academics and practitioners
argue that additional factors, like
momentum or profitability, should be
considered.
●​ Static Factor Assumptions: The
model assumes that the factors remain
stable over time, which may not
account for market or economic shifts.
●​ Historical Dependence: The factors
are based on historical data, which
may not always predict future
performance.

Expanding Beyond Fama-French: The 5

Factor Model
Fama and French later expanded their model
to include two more factors: profitability and
investment. This enhanced model is known as
the Fama-French 5 Factor Model and further
refines asset return prediction. For many
applications, however, the 3 Factor Model
remains popular due to its simplicity and
effectiveness.

Key Takeaways

1.​ Enhanced Return Explanation: The

Fama-French 3 Factor Model goes
beyond CAPM, adding size and value
Module 1: Overview of Valuation Methods challenging to consistently achieve
above-average returns.
Valuation Types of Valuation Methods
-​ representing the process of 1.​ Intrinsic Valuation
determining the worth of an asset, -​ involves determining the intrinsic
a company, or a project. value of an asset based on its
-​ involves various methods and expected future cash flows. The
techniques, each tailored to most common method under this
specific contexts and needs. category is the Discounted Cash
Understanding the nature and uses Flow (DCF) analysis.
of valuation is essential for anyone 2.​ Relative Valuation
involved in financial -​ compares the value of an asset to
decision-making, investment that of similar assets using
analysis, and strategic planning. valuation multiples, such as
-​ the process of estimating the Price/Earnings (P/E) ratio,
present worth of an asset or entity Price/Book (P/B) ratio, and
based on expected future cash Enterprise Value/EBITDA
flows, earnings, or other financial (EV/EBITDA) ratio.
metrics. It involves analyzing 3.​ Asset-Based Valuation
various factors that influence -​ focuses on the value of a
value, including market conditions, company's assets and liabilities.
risk, and growth prospects. This method includes approaches
Principles of Valuation like Net Asset Value (NAV) and
1.​ Value is subjective Liquidation Value.
-​ value of an asset can vary 4.​ Contingent valuation
depending on the perspective and -​ considers the value of flexibility
objectives of the evaluator. and optionality in decision-making.
Different investors may value the Real Options Valuation is a
same asset differently based on common method under this
their expectations and risk category.
tolerance. Factors Influencing Valuation
2.​ Time value of money 1.​ Market Conditions
-​ principle that a dollar today is -​ Economic indicators, interest rates,
worth more than a dollar in the inflation, and market sentiment can
future due to its potential earning significantly impact valuation.
capacity. This principle underlies 2.​ Company Performance
many valuation techniques, such -​ Financial performance, growth
as Discounted Cash Flow (DCF) prospects, and competitive
analysis. positioning of a company are
3.​ Risk and return crucial factors in valuation.
-​ Higher-risk investments typically 3.​ Risk and Uncertainty
require higher expected returns to -​ level of risk associated with an
compensate for the uncertainty. asset or investment affects its
4.​ Market Efficiency valuation. Higher risk typically
-​ efficiency of the market affects the leads to lower valuation.
valuation process. In efficient
markets, asset prices fully reflect
all available information, making it
 4.​ Regulatory Environment them prioritize investments and
-​ Regulatory changes and legal optimize their capital structure.
considerations can influence the 4.​ Financial Reporting
valuation of assets and companies. Purpose:
Uses of Valuation in the corporate world -​ to determine the fair value of
1.​ Investment Analysis assets and liabilities for financial
Purpose: reporting purposes, ensuring
transparency and accuracy in
-​ Valuation is used to assess the financial statements.
attractiveness of an investment Application
opportunity, helping investors -​ Companies use valuation to
determine whether an asset or assess the impairment of assets,
company is undervalued or fair value of financial instruments,
overvalued. and allocation of purchase price in
business combinations.
Application 5.​ Strategic Planning
-​ Investors use valuation to make Purpose:
informed decisions about buying, -​ Valuation supports strategic
holding, or selling assets. For decision-making by providing
example, a stock with a lower P/E insights into the value of different
ratio compared to its peers may be business units, investment
considered undervalued, opportunities, and potential
presenting a potential buying divestitures.
opportunity. -​ Companies use valuation to
2.​ Mergers and acquisitions identify value-creating
Purpose: opportunities, assess the impact of
-​ In M&A transactions, valuation is strategic initiatives, and align their
critical for determining the fair price business strategies with their
of the target company and financial goals.
negotiating the terms of the deal. -​
Application
-​ Acquirers use valuation to evaluate
the potential benefits and risks of a
merger or acquisition. Accurate
valuation helps in making strategic
decisions and maximizing
shareholder value.
3.​ Capital Budgeting
Purpose:
-​ Valuation is essential in capital
budgeting, where companies
evaluate the viability of investment
projects and allocate capital
efficiently.
Application
-​ Companies use valuation to
assess the expected returns and
risks of different projects, helping